PRIVATE CLIENTS GROUP ANNUAL CLIENT UPDATE, December 2008
December 1, 2008
To Our Clients and Friends:
On a periodic basis we write to discuss legal developments that may impact our clients' estate planning. 2008 is a year that has brought about change and the potential for significant future change impacting tax laws and estate planning.
While we recognize that current economic uncertainty has many people focused on other concerns, it is incumbent on us to remind you that it is critical to review your estate plan to ensure it properly addresses both current tax laws and your present financial and family situation. The historically low interest rates and depressed asset values that have accompanied the recent economic upheaval also present unique opportunities for transfer tax planning. This letter is designed to highlight some current estate and gift tax planning issues, as well as to provide you with our annual checklist of reminders for keeping the administration of your estate plan up to date.
As we enter our 100th year, we continue to have one of the largest Trusts & Estates practices in the country as well as significant commercial and litigation practices. We currently have 85 attorneys firm wide, 60 of whom, together with 32 paralegals and fiduciary accountants, are devoted solely to the needs of individual clients. Among our lawyers are 17 Best Lawyers in America, 12 American College of Trust and Estate Counsel Fellows, and one of Worth Magazine's Top 100 Attorneys.
Please feel free to contact your Cummings & Lockwood attorney to discuss any of the items mentioned in this letter or to review any estate planning issues in further detail. We look forward to hearing from you.
ESTATE TAX LAW DEVELOPMENTS AND ISSUES
Future of the Federal Estate and Gift Tax System
If the tax code is not amended by December 31, 2009, current law calls for a complete repeal of the federal estate and generation-skipping transfer taxes in 2010 and a return to pre-2001 exemptions and rates ($1,000,000 exemption and 55% top rate) in 2011 and beyond. It is very unlikely, however, that this will actually come to pass.
While we wait to see what President-Elect Obama and Congress will enact, we continue to operate under the current law created in 2001 which calls for a $3,500,000 million exemption from federal estate and generation-skipping transfer taxes in 2009 and a $1,000,000 lifetime exemption from gift taxes. The 2009 federal estate and gift tax rate on amounts in excess of these exemption limits is set at a maximum of 45%.
President-Elect Obama stated during his campaign that he is against estate tax repeal and has proposed freezing the estate tax law as it will exist in 2009 with a $3,500,000 Federal estate tax exemption and a top estate tax rate of 45%. Accordingly, while no one knows for certain, it is generally believed that the federal transfer tax system will remain in place in some form similar to the current 2009 law. While it can be frustrating to consider estate planning in an uncertain tax environment, we continue to emphasize that it is important to plan for the existing federal estate tax as well as the existing state transfer tax and the certainty that the federal estate tax will remain in place in some manner in 2010 and beyond.
Current federal law relating to estate and gift exemptions and tax rates is summarized in the following chart:
Estate Tax Exemption Amount
GST Tax Exemption Amount
Gift Tax Exemption Amount
Maximum Estate and Gift Tax Rates
Estate Tax Repealed
GST Tax Repealed
35% (Gift Tax Only)
2011 and beyond
$1,120,000 adjusted for post-2003 inflation
Transfer Tax Inflation Adjustments
Because they are tied to inflation, many of the federal transfer tax exemption amounts are scheduled to increase in 2009. The annual gift tax exclusion will increase from $12,000 per person per year to $13,000. In addition, the first $133,000 of gifts to a noncitizen spouse each year will not be treated as a taxable gift which is an increase from the 2008 amount of $128,000.
Future of State Estate Taxes
The 2001 Tax Act made many changes to the Federal estate tax system, including eliminating the Federal government's system for sharing estate tax revenues with the states. In response, many states, including Connecticut, New York, New Jersey, Rhode Island and Massachusetts, established separate state estate taxes that operate independently of the Federal estate tax system. The separation of the Federal and state estate tax systems is commonly referred to as "decoupling."
States have elected to impose different exemption amounts than the Federal system and this will increasingly produce state taxes on estates which would otherwise be sheltered from Federal tax. For example, in 2008 the Federal tax system did not impose estate tax on the first $2,000,000 of estate assets, but New Jersey and Rhode Island taxed assets in excess of $675,000 and New York and Massachusetts taxed assets in excess of $1,000,000. Connecticut residents were not faced with this issue in 2008 and prior years, as Connecticut did not tax estates with assets of less than $2,000,000, in line with the Federal estate tax system. However, as discussed above, beginning January 1, 2009 the Federal estate tax exemption will increase to $3,500,000 while the Connecticut exemption will remain at $2,000,000 thus subjecting Connecticut residents to the same disparity that residents of other decoupled states have confronted in prior years.
The decoupling of the tax systems complicated the field of estate planning, particularly for married couples living in or who own property in decoupled states. Prior to decoupling, most married couples focused solely on the Federal estate tax and implemented estate plans to maximize the use of the Federal estate tax exemption in the estates of both spouses. Historically, this automatically resulted in the maximization of the state estate tax exemptions as well. Due to decoupling, the traditional estate plan technique now will result in state estate taxes being due in decoupled states at the death of the first spouse to die.
Although planning for the Federal estate tax, with a current rate of 45%, is important, state estate taxes are not insignificant. To illustrate this problem, let's suppose a husband dies in 2009 residing in Connecticut or New York and his estate plan leaves the share of his estate that is exempt from federal estate tax ($3,500,000) to a trust (the "Estate Tax Sheltered Trust") that does not qualify for the marital deduction and that will pass free of estate tax at the wife's death. There will be no federal estate tax on the share passing to the trust because it has a value equal to the amount exempt from the federal estate tax. On the other hand, the value of the share of the estate passing to such trust will exceed the state estate tax exemption, and the state estate tax on this excess will be in the range of $230,000 to $255,000.
While it may make sense to pay this state estate tax at the husband's death, in order to avoid estate tax on the additional assets at the wife's later death, we believe that it would be better to delay this decision until the death of the first spouse to die. For that reason, we strongly advise clients who have not already addressed "decoupling" in their estate plans to consider revising their plans to allow flexibility in how and when state estate taxes are paid. With careful planning, a structure can be created by which the Executor of the estate of the first spouse to die can decide the best overall tax result for your family after considering the then current Federal and state estate tax laws and rates as they apply to the actual estate. Creating this kind of flexibility is generally much more beneficial to your family than having a tax result imposed by reason of out-dated documents which did not take into account separate state estate taxes.
Although many of our clients already addressed decoupling in their plans, those who have not done so within the last several years should review their current estate plans with their Cummings & Lockwood attorney to determine if revisions are now in order.
OVERVIEW OF SELECTED FEDERAL INCOME TAX ISSUES
Future of Federal Income Tax
Although it remains to be seen what President-Elect Obama and the newly-elected Congress will enact in the income tax arena, we do know what the president-elect proposed while campaigning. Obama's plan includes some extension of the tax cuts implemented in 2001 and 2003 which are otherwise scheduled to sunset in 2011. Specifically his proposed plan would extend the lower 10%, 15%, 25% and 28% income tax brackets and the lower capital gains tax rate for taxpayers in those four brackets. His proposal would restore the top rates of 36% and 39.6% for high-income taxpayers (those with AGI of $250,000 for married couples and $200,000 for individuals and married couples filing separately). High-income taxpayers also would be subject to a capital gains and dividend tax rates of 15 to 20 percent and continued phase-outs for personal exemptions and itemized deductions. While President-Elect Obama's campaign proposals included discussion of some AMT reform, the specifics of any such reform initiative have not been detailed.
Extension of Certain Provisions of the Pension Protection Act of 2006
The Pension Protection Act (the "PPA") was enacted in 2006 and contained, among many other items, an option for individuals who have reached age 70 1/2 to use funds from their IRA accounts in order to make a direct contribution to charity. Until the PPA was passed, amounts withdrawn from an IRA and then contributed to charity were first included in the account owner's income and then reported as an itemized deduction. The PPA permitted an individual to make contributions of up to $100,000 from an IRA account directly to qualified charities (not including private foundations and donor-advised funds) during 2006 and 2007. The amount the charity receives from the IRA is counted as part of the account owner's minimum required distribution but it is not included in the owner's taxable income and does not generate a charitable income tax deduction. Congress recently extended this provision to allow such direct contributions for 2008 and 2009 as well.
Reduced Tax-Free Exclusion for Main Homes for Non-Qualifying Use
Until now, when homeowners sold their primary home, they could exclude up to $500,000 in capital gains from income tax. The Housing Assistance Tax Act of 2008 changed these rules. The amount of profits from the sale of a house that can be excluded is now based on the percentage of time when the house was used as a primary residence. Homeowners who sell their primary residence still can exclude up to $250,000 (or up to $500,000 for married couples filing jointly) in capital gains from their taxes. However, where a house also is used for purposes other than just a primary residence, (such as if it was used as a vacation or second home at some point or was previously used as rental property), the amount of gain that will qualify for the exclusion is limited based on the amount of time that the house is used as a primary residence Homeowners selling a house that was once used in some manner other than as their primary residence will have to pro-rate the capital gains tax exemption proportionate to the amount of time the house was used as primary residence versus the time it was not. Fortunately, homeowners will be able to plan ahead as the allocation rules take effect beginning January 1, 2009.
Qualified Conservation Contributions
Through 2009 very favorable charitable deductions are available for certain conservation contributions. If you are interested in donating real property interests to a charity (with the gift to take place now or as a future interest to be transferred later) or restricting the use of real property you own for conservation, now could be a particularly good time to consider such a donation or restriction to take advantage of these enhanced deduction opportunities.
SELECTED OTHER DEVELOPMENTS IN ESTATE PLANNING
Grantor Retained Annuity Trusts (GRATs)
Grantor Retained Annuity Trusts (GRATs) are one estate planning tool used to reduce transfer taxes by removing assets from an estate with little or no gift tax implications. GRATs can be particularly effective when interest rates are low, especially if they are funded with assets that are under-valued at the time of funding and likely to see appreciation in the short-term future. Using a GRAT, the donor transfers an asset he or she believes will substantially appreciate in value to a trust, from which the donor will receive a fixed amount annually (an "annuity") for a selected term of years. Using the prescribed interest rate provided by the IRS, the annuity can be calculated so that the gift tax value of the transfer to the trust is nominal. If the donor survives the GRAT term, when the term ends all appreciation of the assets in the trust in excess of the IRS presumed interest rate are transferred tax free to the beneficiaries designated in the GRAT. The lower the interest rate provided by the IRS, (an extremely low 3.4% for December 2008), the greater chance the GRAT will succeed in transferring substantial value out of the donor's estate with no tax costs.
Direct Transfers of Depressed Assets To Trusts or Individuals
The recent market downturns have resulted in depreciation of many assets. If you have assets which you believe are likely to see a return to significantly greater value in the future, now may be the time to take advantage of depressed asset values by making direct gifts to family members or trusts for their benefit at artificially low values. If you historically make your annual gifts to family members or trusts in cash, you might consider making your 2008 and 2009 gifts with recently devalued securities or other assets. Now also might be the time to consider using all or a portion of your $1,000,000 lifetime exemption to gift assets to a Spousal Estate Reduction or Dynasty Trust for your family. As there are potential capital gains issues to consider and because the timing and structure of such gifts must be reviewed and coordinated with your overall estate plan, we recommend that you discuss any planned gifts with your C&L attorney before making any transfers.
Qualified Personal Residence Trust ("QPRT")
The Qualified Personal Residence Trust ("QPRT") can be an effective means of transferring your residence out of your estate at a reduced transfer tax cost. The concept is simple: the owner of a personal residence transfers it to a trust, but retains the right to live in the residence for a specified period of years. At the end of that period of years, the trust beneficiaries become the owners of the residence. Thereafter, the residence will no longer be a part of the donor's taxable estate. The tax advantage of the QPRT comes primarily from the way in which the value of the gift to the trust is calculated for gift tax purposes. The gift tax value is discounted to reflect the donor's right to keep possession of the property for a number of years. The discount is calculated using an interest rate provided by the IRS. Although QPRTs historically perform better when interest rates are high because higher interest rates provide larger gift tax discounts, the current state of the real estate market may allow the successful transfer of future appreciation despite low interest rates, so now may be the time to consider a QPRT.
Sales of Assets to Trusts
Another technique for removing assets from an estate, particularly for people who have used their $1,000,000 lifetime gift exemption on prior gifts, is to sell assets to a trust for the benefit of family members. If the trust is created as a "grantor trust" the sale of assets can be structured to avoid current capital gains taxes. Such a sale often involves selling an asset that has a depressed value or on which a discount in valuation can be taken. Typically, a substantial portion of the consideration paid by the trust consists of a promissory note. The promissory note can be paid back over a long period of time and can even be "interest only" for a number of years. Such a transaction has the potential to remove from the seller's estate the appreciation on the assets sold in excess of the interest paid. The Promissory Note must be commercially reasonable (bearing interest at a minimum equal to the IRS's Applicable Federal Rate ("AFR") for the term of the Note). The current low interest rates make these transactions particularly attractive.
Family Loans and Refinancing of Loans
Now may be an ideal time to loan a family member money or to refinance an existing loan to a family member. Such a loan may help a child or other family members in need of some financial assistance or allow a family member to invest borrowed funds and keep the excess of the return on investments over the interest paid on the loan. Similar to the sales to trusts discussed above, in order for the IRS to respect the transaction as a loan and not treat it as a gift, the loan must be commercially reasonable but with interest rates at historic lows, the Note can still have a low interest rate. In addition, if you have already loaned a family member money, now might be a good time to re-finance the existing loan at a lower interest rate. Please note that family loans must be an arms length transaction which should be documented by a Promissory Note (or a recorded Mortgage Deed if the loan is for the purchase of a home).
Potential Changes to Valuation Discount Rules for Gifts
Potential changes to valuation rules may make gifts more costly after 2008. The Congressional Joint Committee on Taxation has long been considering changes to the valuation of gifts of closely-held and family business interests. Under existing valuation principles, the value of such interests often can be discounted due to lack of marketability, minority interest and fractional interest considerations. In 2005, the Joint Committee considered eliminating such discounts for intra-family transfers, including transfers of fractional interests in real estate. With the election of a Democratic President and Democratic Congress, some commentators believe the 2005 proposal will be revisited and possibly enacted in some form, perhaps as early as 2009. If you are considering a transfer of an interest in real estate or a business entity, time may be of the essence for completing this transaction before the end of 2008 to take advantage of the existing valuation discount rules.
Insurance Mortality Tables
In 2008 several carriers have transitioned to the new CSO 2001 Mortality Table to price insurance policies. All carriers will be implementing the new table in 2009. This new mortality table has had a dramatic impact on policy pricing. We wanted to make you aware of this because there may be an opportunity to reduce the cost of existing coverage or look into purchasing new coverage at more competitive costs especially for older insureds. In our opinion, it makes sense to evaluate your existing coverage for possible improvements. Trustees of irrevocable life insurance trusts have an obligation to do this periodically.
ESTATE PLANNING DEVELOPMENTS IN FLORIDA
New Florida Trust Code
Florida enacted a new Trust Code effective July 1, 2007. If you are (or will be) a Trustee of a Florida Trust, you should review your fiduciary responsibilities under the new Trust Code. For example, trustees of Florida trusts must now provide accountings annually to trust beneficiaries. This includes a surviving spouse acting as Trustee of a trust created by a deceased spouse. However, you may draft your Florida Trust to alter or add to a Trustee's responsibilities. Please contact your Cummings & Lockwood attorney who can advise you on the various aspects of the Florida Trust Code and how they might apply to your particular circumstances.
Florida Homestead Issues
Florida law restricts the manner by which a Florida resident can devise his or her homestead upon death. For this reason, your beneficiaries may need to obtain a legal determination of your ability to dispose of your homestead according to your estate plan. The extent of such a determination varies from case to case. To minimize the need for such determinations, we generally recommend that you not hold your homestead property in a revocable trust. To determine what type of determination might be required in your case, please consult your Cummings & Lockwood attorney.
Loss of Tenancy By the Entirety Protection for Certain Bank Accounts
Florida law recognizes a property ownership concept known as a "tenancy by the entireties" that may exist when a married couple owns property jointly. Property owned as a tenancy by the entireties ("TBE property") provides asset protection, as a creditor of only one spouse cannot reach TBE property to satisfy the creditor's claims. Recently, a national banking institution notified married depositors that the institution would no longer treat joint accounts owned by a husband and wife as TBE property, even if the account is titled as such. Simply put, the institution has now made it difficult, if not impossible, for the couple to treat an account as TBE property and to gain the asset protection that form of ownership provides. We encourage you to contact your own banking institutions to consider whether the TBE status of your bank accounts are similarly jeopardized. Regardless of an institution's ownership policies, spouses should also consider executing a separate document that expresses their intent that a joint account is TBE property.
Year end is a good time to review your estate plan to be sure administrative tasks have been completed and to ensure that your plan continues to be appropriate for your personal and financial circumstances and takes full advantage of changes in the tax laws. We have attached our annual estate planning checklist to assist you with this review.
Copyright 2008, Cummings & Lockwood LLC. All rights reserved.
In this Update and the attached checklist, we have deliberately simplified technical aspects of the law in the interest of clear communication. Under no circumstances should you or your advisors rely solely on the contents of this Update for legal advice, nor should you reach any decisions with respect to your personal tax or estate planning without further discussion and consultation with your advisors.
In accordance with IRS Circular 230, we are required to disclose that: (i) this Update and the attached checklist are not intended or written by us to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer; and(ii) this Update and the attached checklist were written to support the promotion or marketing of the transaction(s) or matter(s) addressed by such materials; and (iii) each taxpayer should seek advice on his or her particular circumstances from an independent tax advisor.
ANNUAL ESTATE PLANNING CHECKLIST
Will 2009 Bring Any Estate Planning Events?
Consider whether upcoming events will necessitate any changes to your estate plan. Are there potential family changes (marriage, birth or divorce), business issues (new job, establishing a new business or the potential sale of an existing business), or estate planning events (a significant change in assets, a change in domicile, or the pending "expiration" of a trust such as a GRAT or QPRT) in your future?
Are Your Assets Properly Coordinated With Your Estate Plan?
An essential part of the estate planning process is to coordinate the beneficiary designations on assets such as retirement plans and life insurance with your estate plan. It is a good idea to periodically review these beneficiary designations to be sure they have been recorded properly and don't require updates. In addition, if you are married, your estate plan likely provides for an Estate Tax Sheltered Trust for the benefit of a surviving spouse. This type of plan requires that each spouse owns in his or her own name assets with a value at least equal to the amount exempt from federal estate tax ($3,500,000 in 2009) to take maximum advantage of estate tax exemptions. In light of recent troubles with some financial institutions, you also may want to consider the FDIC insurance and other protective limits when reviewing title to your assets.
If You Own A Business, Have You Properly Implemented A Business Succession Plan?
If you own interests in a family or closely-held business, it is important for both business continuity and for tax planning that a succession plan is in place to address lifetime and death related changes in management and ownership. If you have not yet created such a plan, now is the time to consider your options. For those with a succession plan already in place, year-end is an excellent time to review the details of the plan to be sure it reflects your intentions and is up-to-date.
Do You Have Up-to-Date Powers of Attorney and Living Wills?
Generally, Durable Powers of Attorney and Living Wills remain legally valid until they are specifically revoked. However, the more recent these documents, the more likely they are to be honored without question or hurdles. We encourage you to sign new Powers of Attorney and Living Wills at least once every five years.
Have You Taken Full Advantage of Your 2008 Gifting Privileges?
Under the current tax law, you may make gifts of up to $12,000 per recipient each year (or $24,000, if you and your spouse elect to "split gifts" on your gift tax returns) free of Federal gift tax and without a reduction of your Federal lifetime exemptions from estate and gift tax. Unlimited gifts are allowed for tuition (if paid directly to the educational institution) and medical payments (if paid directly to the medical provider). Please bear in mind that payment of insurance premiums for insurance held in an Irrevocable Life Insurance Trust and some other transfers to trusts are gifts to the trust beneficiaries for the purpose of determining whether you have fully used your gift tax annual exclusion.
Do You Need to File 2008 Gift Tax Returns?
The gifts you make in 2008 may need to be reported on a federal (and possibly a state) gift tax return, which is due on or before April 15, 2009. A Federal Gift Tax Return should be filed for gifts that exceed or do not qualify for the gift tax exclusion, for most gifts to trusts, for gifts that you want to "split" between you and your spouse and/or if you wish to make certain elections relating to the use of your generation-skipping transfer tax ("GST") exemption. Also, if you have a Grantor Retained Annuity Trust ("GRAT") or Qualified Personal Residence Trust ("QPRT") that will terminate soon, you may need to file a gift tax return to opt out of the automatic allocation of GST exemption to any continuing trust for your beneficiaries.